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Steel: Good! But, what next?

Introduction

One sector that continues to hog the limelight on the bourses is steel, which is vindicated from the fact that most of the steel stocks have outperformed the benchmark indices by a wide margin over the last couple of years. However, much of the gains in steel stocks were witnessed during FY04 and if one considers the last 12 months' performance, the outperformance has been relatively lower. The trigger for the continued momentum in steel stocks has been the strength in the steel cycle, which has managed to sustain right through FY05 (contrary to our expectations of peaking in 1HFY05) and if the recent developments in the sector are to be considered, the near-term momentum is likely to hold. In this backdrop, we take a look at the 9mFY05 consolidated performance of some steel companies listed on the bourses and see what is in store for the sector going forward.

9mFY04

9mFY05

Change

Net Sales

278,543

389,537

39.8%

Expenditure

215,777

253,229

17.4%

Operating Profit (EBDITA)

62,767

136,308

117.2%

EBITDA margin (%)

22.5%

35.0%

Other income

2,274

3,583

57.6%

Interest

14,567

15,217

4.5%

Depreciation

17,542

19,324

10.2%

Profit before tax

32,931

105,350

219.9%

Extraordinary items

(842)

(2,499)

Tax

6,138

31,387

411.4%

Profit after Tax/(Loss)

25,951

71,463

175.4%

Net profit margin (%)

9.3%

18.3%

* Includes Tisco, SAIL, Essar Steel and Ispat

Industry background

India, with its 34 million tonnes per annum (MTPA) total steel producing capacity, is the world's 8th largest steel producer in the world. However, India's per capita consumption of steel is at around 30 kgs as against over 200 kgs in China and an average of 450 kgs in developed nations. This indicates tremendous growth potential considering the low consumption of steel in the country.

What has driven performance in 9mFY05?

China aids the growth: As can be seen in the table above, the consolidated topline of the 4 companies has registered a YoY growth of 40% during 9mFY05. It must be noted that this growth is primarily a factor of strengthening steel prices. Average steel prices during the period under consideration were higher by 33% as compared to the same period last year.

Sustained demand for the metal from China, which consumes about 25% of world steel, is the big pillar that has supported the steel cycle as yet. With the Chinese economy growing at over 9%, huge investments are being made in infrastructure and housing related activities. Further, with the US and the EU economies also having shown signs of strength, steel prices in those regions have also firmed up. On the domestic front too, high activity on the housing and infrastructure fronts (thanks to the government's housing tax breaks and road development programmes), has kept steel prices ticking. The demand-supply scenario continues to remain favourable currently.

High realisations and cost management aid margins: On the back of a sharp improvement in realisations, the consolidated operating margin of steel majors has improved from 22.5% in 9mFY04 to 35% in 9mFY05. While much of this surge in margins is on the back of sharp improvement in steel prices, it would be inappropriate to take away the credit from steel players for managing their costs in a more efficient manner and the productivity improvement put in place by them.

It all flows to the bottomline: All of the above factors have consequently led to the consolidated net profits of the steel pack under consideration grow by 175% YoY. However, apart from the operational improvements, interest costs, which have played an important part in determining the bottomline growth of steel companies, continued to lend a supporting hand to the industry, thanks to the soft interest rates prevailing since the last few years. Steel is a highly leveraged industry. Thus, lower interest rates helped steel companies to re-shuffle their high cost debts with lower interest bearing debt. The cyclical upturn in the industry, which in turn improved cash flows, also helped companies to pare their debts significantly. Further, assistance from financial institutions and the government in terms of debt restructuring had come as a boon for the industry, which accelerated their turnaround and helped them come out of the trough. This, combined with strong volume sales and even stronger realisations aided the industry reap fortunes.

What to expect?

Going forward, while the demand scenario looks encouraging with China's efforts having failed (as yet) to reign in its economic growth and increased consumption in regions like US, EU and Russia, it is concerns on the supply front that could take toll on steel prices. With most steel majors having already announced their capacity expansion plans, the increased supply in the medium-term could pose a serious threat to the sustainability of steel prices at the current levels.

Further, China continues to remain one of the key determinants of how the performance of the sector would pan out over the next couple of years, as any shortfall in demand/imports from the country would lead to increased availability of steel for the international markets. This belief is further strengthened by the fact that as per reports, China was a net steel exporter in the closing months of 2004 as it increasingly meets its metal demand internally. Also, with prices of inputs like iron ore (up around 150% YoY), coal (up around 200% YoY), coke (up around 125% YoY) and scrap (up around 230% YoY) having skyrocketed, it is largely the vertically integrated players like Tisco and SAIL that would remain insulated to a certain extent and not the entire sector. Thus, over the medium-term, we would advise caution to investors considering the risk profile of the sector at the current juncture. There is a need to separate the wheat from the chaff!

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